Pages

Thursday, 18 October 2012

What is the difference between bottom-up and top-down investing?

There are so many investment strategies out there that sometimes it is hard to know exactly what all of them mean, whether they can be applied in your actual personal investment portfolio or whether they should be left to the professionals. In this post I will be covering the difference between bottom-up and top-down investing.

Defining bottom up and top down investing

The difference between these two types of investing unsurprisingly relates to what point in the investment universe you start looking. Do you start at the bottom looking at individual stocks or so you start at the top thinking about industries and macro considerations?

Bottom up investing starts wit the hunt for cheap companies and then overlays other considerations such as the macro environment on top later. The most important consideration to these investors is the company and stock that they are investing in which then gets context applied to it. Most traditional value investors fall within this category.

Conversely for top down investors the context is the most important part of the equation. They try and spot or think of the big macro trends and structural factors which will affect valuations. Once they have researched this theory they then search for the best companies conforming to that theory. A lot of macro and hedge fund investors use this approach - for example think about those funds that bet against housing during the GFC . they were thinking about industry considerations not about individual stocks

Why does it make a difference?

It makes a difference because it fundamentally affects how you are thinking about your investment proposition and the framing of the investment question. The fact is that each person is different and the way they tackle this question will be highly dependent on their individual investment experiences as well as the way they think about the world.

Both approaches have their upsides and downsides (and their limitations):

With top down investing you are constantly going through a 'narrowing' process

You find a 'big picture' that you want to trade on and you keep narrowing down the options until you get to a stock and company that you like

This has the benefit of understanding structural reasons before you get enamoured with any stock in particular

The disadvantage however is that you potentially miss good deals in sectors which are not doing a lot but where a stock may be very mis-priced

With bottom up investing the approach is much less limiting

Although most people specialise in some sectors or understand some sectors better than others the fact is that bottom up investing is a lot less limiting - you are free to look for good deals everywhere

The disadvantage though is that you can miss potentially important structural factors which can affect the value of the stock you are investing in regardless of how good the value appears to be

Are they mutually exclusive?

While all professional money managers have a view and a style which takes primacy in their investment approach, I think that all apply both techniques in some form. A bottom up value investor will always look at the macro considerations to see whether there is a structural reason that the stock they are looking at is so cheap while a top down macro investor will always start with their hypothesis and then look for the stock with the best value proposition which conforms to the macro idea.

These two investment approaches are not mutually exclusive however one will normally come first in an investors thinking and it really has to do with the investment approach that each individual takes.

What should you do?

So now that you know what the difference is - do I think one way is netter than another? In all honesty I think that while it is important for professional money managers to define their thinking around these ideas, I think that the average person investing on their own behalf has only limited time each day to think of investment ideas.

If you have an idea which gets you going you should pursue it regardless of whether you see yourself as a 'bottom up' or 'top down' investor - the fact is that your investment mentality will probably drive you to one point or the other. The research process that you go through should automatically incorporate both concepts as I explained above.

Be aware that almost every investment book you read will push one method over the other and make it sound like the only 'correct' idea. the reality is much more subtle than this and keeping this in mind will allow you to think about what you are reading much more critically.